One of the most significant risks facing a business seller is the cost associated with educating a potential purchaser in the event a deal falls through. It is standard practice to require any potential acquirer to execute a non-disclosure agreement, but the breadth of that contract can go a long way to mitigating the seller’s risk.

Most buyers will balk at an industry non-compete clause following failed negotiations. Indeed, in most cases, the buyer will already have substantial experience in the seller’s business. But often times, a general non-disclosure clause will not be enough to protect the seller. A recent case out of Alabama serves as a compelling example.

In 2006 and 2007, an entrepreneur named Mark Greenshields became interested in purchasing a video-racking division owned by Movie Gallery US, LLC. This business involves placing movie rentals in racks at consumer locations, such as grocery or convenience stores. The deal fell through in May of 2007, and Greenshields started his own video-racking business shortly thereafter. He hired three former Movie Gallery employees within a few months after the transaction imploded, and the new business eventually took about ten former Movie Gallery customers.

It’s not at all clear that the defendants’ monetary exposure was that great. Movie Gallery itself had been losing money in this business and was trying to jettison the video-racking division to focus on more profitable business segments. However, it sued Greenshields and the entities he formed for breach of the transaction non-disclosure clause.

The court, ruling under Alabama law, found that Movie Gallery failed to prove that the defendants breached any confidentiality obligation. Noting the evidence largely was circumstantial, the court highlighted the following as important flaws in Movie Gallery’s theory of breach:

(1) Less than half of the defendants’ new customers were ex-Movie Gallery customers;
(2) Ten customers was a relatively small number given that three former employees were working full-time in the business;
(3) No profitability analysis was ever conducted on the lost customers, suggesting that there was no evidence defendants targeted profitable, quick-paying accounts;
(4) The supply sources were known by the new employees given their long history in the business;
(5) The customer lease agreements were drafted by defendants’ counsel, and the terms were generally known in the business and ascertainable simply by asking the customers themselves.

The court was unable to make the leap in logic demanded by Movie Gallery: that Greenshields had to be using information disclosed to him during due diligence of the failed transaction. The following summarizes succinctly the quandary faced by the court, which suggests it believed Movie Gallery should have required Greenshields to sign a more extensive non-disclosure agreement:

“The fact that Greenshields may have, through viewing confidential information over the course of several months, become more familiar with the specific accounting and business principles involved in a racking operation surely is not the equivalent of his using specific pieces of confidential information….[The non-disclosure] agreement specifically contemplated that Greenshields may compete, and it is only logical that Movie Gallery could not expect him to rid his mind of general knowledge acquired through his months of studying an industry new to him.”

At a bare minimum, a seller of a business ought to require a buyer not to hire or engage a seller’s employees for a period of time. In a case like Greenshields’, his lack of experience in the business was not a deterrent to opening a competitor rather quickly; he took three long-time employees away from Movie Gallery to do the leg work.

Additionally, sellers need to consider limited customer non-solicitation covenants requiring a purchaser to avoid certain accounts following the termination of a potential deal. Sellers also can line-out customer names until the transaction negotiations reach a certain point, but in many cases this is neither feasible nor acceptable.

Here is a scenario to ponder.  A Debtor issues two Promissory Notes, one to Creditor A and the other to Creditor B.  The Note to Creditor A is dated earlier and is secured by a properly perfected pledge in the Debtor’s stock.  The Note to Creditor B is secured by a properly perfected and filed UCC financing statement on all assets of the Debtor.  There is no Intercreditor and Subordination Agreement between Creditor A and Creditor B.  Debtor defaults.  Would you rather be Creditor A or Creditor B?

Article 9 of the UCC addresses a number of priority scenarios when different creditors lien against the same asset. See 810 ILCS 5/9-317 to 810 ILCS 5/9-339. However, it does not provide much guidance as to the practical economic effect of two creditors who properly perfected their liens against different assets.

In the scenario above, Creditor A may enforce its pledge to gain voting control of the Debtor and attempt to sell the business.  However, Creditor B still has a valid lien against the Debtor’s assets that will not be extinguished by Creditor A assuming control of the Debtor.  Creditor B can still proceed against the assets and recover its obligations, possibly leaving Creditor A with a shell company.

Creditor A would be in a better position if it had an Intercreditor and Subordination Agreement with Creditor B that ensured Creditor A was paid off before Creditor B.  However, this scenario also presents the lesson to creditors often cited by Alastor “Mad-Eye” Moody in the Harry Potter books – “Eternal Vigilance.”  Know what your debtors are up to and what encumbrances they are racking up.

This scenario also highlights certain limitations of using stock pledges to secure debt.  These will be explored further in a later blog.

Dissociation occurs when an owner of a business ceases to be associated in operating the business, voluntarily or involuntarily.  In such a case, the withdrawing owner may want his ownership interest redeemed.

Shareholders of closely held corporations typically do not have the right to require a corporation to redeem their shares.  Unless a shareholder acquires redemption rights by contract or can have the corporation dissolved for certain misconduct (See 805 Ill. Comp. Stat. 5/12.50), the shareholder will not be able to withdraw from the corporation and receive payment for his shares.

In contrast, many partnerships were formed as “partnerships at will” giving a partner greater flexibility in withdrawing from the partnership. See 805 Ill. Comp. Stat. 206/801.

Since LLCs are hybrid entities with characteristics of both corporations and partnerships, the drafters of the state LLC Acts had to decide which entity they wanted LLCs to resemble.

Delaware treats LLCs similar to corporations by preventing the resignation or withdrawal of a member unless specifically authorized by the operating agreement.  See Del. Code Ann. 6, § 18-603.

Illinois has a more nuanced position. Illinois treats “member-managed” LLCs similar to partnerships by granting members the power to dissociate. See 805 Ill. Comp. Stat. 180/35-50. However, if the dissociation violates the terms of the operating agreement, the LLC may recover its damages as a result of such wrongful dissociation. The Illinois LLC Act does not provide much guidance as to how such damages are to be calculated. If the LLC does not dissolve as a result of the dissociation, the dissociated member’s interest must be purchased within 30 days after dissociation.

In contrast, a “manager-managed” LLC is treated akin to a corporation. The right to dissociate exists only if expressly granted by the operating agreement.

The different dissociation rights granted by the Illinois LLC Act is a major factor to consider in choosing the management structure of the Illinois LLC.  An obligation to repurchase a member’s interest could be a major financial burden on the LLC. Also, the entity may not be viable if one or more members have the ability to withdraw their investment at any time. Likewise, the operating agreements of Illinois manager managed LLCs should be reviewed to ensure that they do not unintentionally grant dissociation rights.

The Florida Supreme Court will shortly deliver its decision on the question certified to it by the Eleventh Circuit under FTC v. Olmstead, et al, 2008 US App LEXIS 11393 (May 29, 2008) as to whether creditors of single member Florida LLCs are limited to charging order remedies.

Ever since LLCs came into existence, legal and financial planners have taken advantage of the asset protection granted by the limited liability company acts (“LLC Acts”) limiting creditor remedies to charging orders. A charging order provides a creditor with a lien on the debtor’s distributional interest in the LLC. By denying the creditor the right to levy on the debtor’s membership interest and obtain voting rights, it limits their remedy to the amount of distributions (if any) made by the LLC.

The charging order remedy originated in common law to protect non-debtor partners from being unwittingly forced into partnership with a creditor. Nevada has extended this concept to certain small business corporations. See Nev. Rev. Stat. 78.746(1)(bb) and Nev. Rev. Stat.78.746. However, this justification does not exist in a single member LLC. Even though the LLC Acts do not limit charging order protections to multi-member LLCs, the plain language of the statutes is under attack in cases like Olmstead.

Charging order protections for single member LLCs were first overturned by the United States Bankruptcy Court for the District of Colorado in In re Ashley Albright, 2003 Bankr. Lexis 291. However, that case has not yet been followed by any state court interpreting its own LLC Act. The decision of the Florida Supreme Court in Olmsteadcould be the next domino to fall. It is time for planners to reassess whether single member LLCs meet their intended purpose and to what extent alternative asset protection plans can avoid judicially created creditor remedies.